Macro: Inflation and Policy

August is winding down. The market-moving data is passed.  Most of the high-income countries, with the notable exception of the UK, reported disappointing economic data in recent days. US data was decidedly mixed. On one hand, August manufacturing surveys from the NY and Philadelphia Fed showed a cooling off of activity, there was an unexpected increase in weakly jobless claims.  On the other hand, US housing activity continues to recover dramatically, and the preliminary PMI was surprisingly strong.

Nevertheless, balance,  there seems to be angst over the strength of the recovery after the initial bounce in many high-income countries.  It is not clear what a vacation means under Covid, but a quieter economic calendar in the week ahead may also see lower participation.  Such conditions can make for choppy price action.

The US diary is not empty next week.  July's income and consumption data will help shape expectations for Q3 GDP.  After falling by nearly a third at an annualized pace in Q2, the median forecast is for output to increase by around a fifth.  The combination of slower re-openings due to new outbreaks in the virus and the loss of some fiscal support, warns of downside risks to the forecasts.

After surging by 12.1% in April, due to fiscal initiatives, personal income fell 4.4% in May and another 1.1% in June.  It may have eased a little in July, but a larger decline in August is likely as the $600 a week in federal unemployment insurance expired.  Consumption fell by nearly 20% in the March-April period and rebounded by 8.5% in May and 5.6% in June.  July consumption expenditures are expected to have risen by a solid 1.5%.

At the same time, more people seem to be talking about inflation.  The monthly gains in July PPI and CPI were above expectations.  At 1.6%, the core CPI reached a four-month high.  The 10-year breakeven (the difference in yield of the conventional note and the inflation-protected yield) rose above 1.70% last week for the first time since January.   It ended last year, a little higher, around 1.78%. 

The five-year five-year forward is another market-based measure of inflation expectations.  It is also looking at breakevens, but here we are interested in the projected average rate of inflation over five years, five years from now.  It rose to six-month highs last week near 2.07% but finished the week below 2.0% (~1.94%).  

Another source of insight into inflation expectations can come from survey data.  The University of Michigan's final August reading will be released at the end of next week. The preliminary estimate of 2.7% matched the level seen in May and had not been seen since early 2016.

The heightened sensitivity to inflation makes the consumption deflator arguably the most important data point for the week.  Although officials talk about the core PCE deflator, it has defined price stability in terms of the headline deflator, which includes food and energy.  It bottomed at 0.5% in April and May before rising to 0.8% in June. It may have risen to 1% in July.  It stood at 1.6% at the end of last year. The core rate may rise 0.5% in July for a year-over-year rate of 1.3% (vs. 0.9% in June and 1.6% at the end of 2019).

Talk that the Federal Reserve is considering formally recognizing an average inflation target also may be underpinning inflation expectation.  Given the undershoot of inflation, an average-inflation regime would not tolerate an overshoot.  There would not be a pre-emptive move as inflation approached 2%.  This is part of the reason the Jackson Hole symposium, a virtual event this year,  will be closely monitored.  Insight into the new monetary policy framework is expected to be gleaned from paper topics and discussions.  In the current context, inflation concerns can serve as a rear-guard action to pullback from additional stimulative measures.

Neither of two seemingly essential conditions for an increase in the general price levels is present.  The first, from a monetarist perspective, the money supply has grown, but the velocity of it has fallen. Without an increase in velocity, money supply is, in effect, not turned into a strong enough fuel to lift prices.  The second condition is supply constraints in the factors market capital and labor.  Yet, the unemployment rate is above the peak of the Great Financial Crisis, and almost 30% of the US industrial capacity is idle.  Of course, that does not mean that there cannot be bottlenecks in different product areas, like lumber now (lumber futures have risen from about $282 for 110k board feet to over $782 over the last five months) that lift prices.

Moreover, central bankers in the high-income countries seem as surprised as anyone by the stubbornly low levels of inflation.  They have tried everything in the playbook plus innovated, and still, inflation has proved elusive.  Look at everything the BOJ has done--in terms of the percentage of JGBs and equity ETFs it owns, and it can barely generate an increase in the general price level.  The record of ECB's July meeting noted that headline inflation was soft and underlying measures were decelerating.  Wage pressures slowed.  The Fed itself has not achieved its target since 2012.

Even pledging not to lift rates until the PCE deflator is at 2.5% or 3% might not raise inflation expectations.  It is a type of forward guidance that essentially says something like, "After undershooting the inflation target for eight years, we declare our desire for an even higher rate."  This is where a credibility issue emerges.  If the Fed could not achieve 2% inflation, is it really meaningful to say that it would like even more inflation now?

Investors are confident that the Fed will not be raising interest rates for years.  The five-year note yield fell to a record low below 19 bp in early August and, in any event, has spent very little time over the past two months above 30 bp.  The implied yield of the fed funds futures strip, which is the cleanest read of policy expectations, is clear on this point and without being impacted by the Fed's purchases or other distortions.  The fed funds futures strip after March 2022 continues to imply a slight chance of a negative effective average rate.

Gold rallied to a record high near $2075.50 on August 7, culminating a nine-week 20.7% rally for the history books.  It sold off by a dramatic 4.4% in the second week of August to end the streak and did not find a solid bid until it fell below $1865,  as late longs and momentum traders were chased out.  Last week gold resurfaced the $2000 level but was greeted with fresh sales seemingly after the Fed's minutes dampened expectations for "yield curve control" or increasing its asset purchases.

Some see inflationary concerns evident in the appreciation of the yellow metal, though we suspect were inflation to really rise,  investors may flock to other assets than gold.  There are several compelling arguments for gold outside of inflation expectations.  Our initial case rested on low and negative interest rates, while others emphasized it as a hedge against equities when yields are already extremely low.

Economic, financial, and geopolitical uncertainty offered a favorable backdrop for gold, and the prospects of the end of the third significant dollar rally since the end of Bretton Woods also make for an arguably compelling narrative.  One investment bank report explicitly linked gold's rally to the decline of the dollar's role in the world economy.   Counter-intuitively, the higher price of gold seemed to boost demand. Its luster attracted the eye of momentum traders and trend followers.

One of the implications of a benign view of inflation is that it allows central banks more latitude to respond to economic and financial conditions.  Until there is a vaccine, it is difficult to envision anything but an incomplete recovery.   It appears that the major central banks working toward shifting framing from being firefighters to facilitators of economic expansion under these constrained circumstances.  The minutes of the July FOMC meeting showed a reluctance to commit to a particular course of action, but that was a month ago when it still seemed reasonable to expect Congress to provide more stimulus for which the Fed was a vocal advocate.  Powell's speech at Jackson Hole on August 27 will be scrutinized.

Moreover, some high-frequency data appears to be already picking up the impact of the loss of the supplemental unemployment insurance, and both the Empire State and Philadelphia Fed surveys for August disappointed.  Some of the protection associated with the Payroll Protection Program (loans morphed into grants) will end for many in the coming months. 

Other countries are facing similar choices, and many have begun trying to navigate a shift from wage subsidies to jobless benefits.    In Germany, Finance Minister, who will be the Social Democrat candidate for chancellor next year, has called for extending its short-term work program for 24 months from 12.  The German research group IFO estimates that the number of short-time workers ("kurzarbeit") in July was around 5.6 mln, down from a peak of 7.3 mln.  UK Chancellor Sunak is under increasing pressure to extend funding for the furlough program that is supporting around two million people. Canada has announced both a four-week extension of its emergency income program before modifying initiatives to put them on a more sustainable basis. 

It is painfully obvious, but the course of the economy will be driven by the virus and the ability to limit the contagion with local shutdowns until a vaccine is available.   Fiscal and monetary policies can offer a bridge until then, but the open-endness of the necessary commitment can erode the political will.  Of course, the exact balance is difficult, if not impossible, to achieve.  More within our ability is to choose the kind of mistake we are more willing to make.  Drawing from the experience around the Great Depression and the Great Financial Crisis, if there is an error pattern, it is for too little too late and removing it too early.

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